Deconstruction of the Value Chain

In the last video, we have talked about the exponential evolution of digital
technology and how this can be the foundation for a massive change for individual
organizations. 

Now let's go one step further and look at how business architecture as a whole has
been transforming in the recent years. 

What I mean by business architecture is how players in an industry are organized
to deliver a certain value add to the end users. This includes competitors, suppliers
and players from adjacent industries, how do they interact together and who do
they interact with. Industry architecture plays a huge role in determining a given
company structure, processes and ultimately its business strategy.

Historically, the architecture that we often use to describe how business is

organized in a given industry was a value chain, a vertically integrated one. In this
model, an industry can be seen as a succession of many suppliers, producers, and
distributors. As a whole, they transform raw input to market-ready material, all
that one step at a time. 

A company would typically integrate multiple steps in the value chain to become 
a member of an oligopoly with a couple of other vertically integrated competitors. 
Vertical integration was the right strategic answer to managing the flow of goods
and information. 

There were two reasons for that.  First, transaction costs were high. A company
required lots of resources and time to orchestrate its value chain, to coordinate
with multiple suppliers, distributors to figure out what is the best price or the right
quality standards. Therefore, less transactions along the value chain meant lower
costs and faster time to market. The second reason is that in many
industries, competitive advantage was driven by scale. The more phones the
company makes for example, the more their experience translates into efficiency, 
and the more profitable they become. 
You may notice that many of those reasons are about information: information
accumulation, information exchange, and information processing. And this is where
digital technology has changed very quickly over the years. 

If you remember the three fundamental laws from the previous video, we have
described how some of the technological progress is passed on to the users as cost
reduction. So it became cheaper and cheaper to store, process, and communicate
information in digital form. 

In practical terms, it became exponentially cheaper for companies directly check

the inventory of their third party distributors through an ERP integration for
example, or to instantly compare prices between suppliers through an online
auction portal. 

These are all examples of decline in transaction costs. It impacted virtually any
industry you can think of. And as a major consequence of that, links in the
vertically integrated value chain became looser and started to break up. This way,
you end up with different layers fulfilling the same functions as before in the
industry. 

But, this time, each layer contains several independent players interacting with
each other independently and interacting with the rest of the layers. This
independence and inter-operability allowed each layer to evolve with its own key
success factors. 
Some layers were scale sensitive so the players naturally consolidated sometimes
to the level of building a monopoly. Other layers needed more innovation and
agility so players remained fragmented.

Let's see how this story of deconstruction has unveiled in the telecommunications

industry as an example. In the 20th century, telephony was offered as an end-to-
end service. A single company will physically wire the homes, manufacture the
handsets, and operate the switch inboard. 

The first stack end of the industry happened after a long legal battle that allowed
customers, and I know this will surprise you, to use a phone not manufactured by
their network service provider.Technologically, this was possible in the early 20s
but the legal battle was only settled in the mid 50s. Then in the 80s, the second
stack end happened. 
Different service providers could rely on a common infrastructure operated by a
third party which benefited from a lot of scale. Then in the 90s with the
emergence of internet, new services started to be offered by new players on top of
the service providers, not only voice communication but also information
services, entertainment, and very, very soon e-commerce. 

This deconstruction of the value chain allowed players in each layer to compete on
what matters for their specific functionality. At the bottom, the key success factor
was scale. Fewer players but enough scale to optimize investment and utilization
of very expensive assets. There was no benefit in having five players duplicate in
the fiber wiring in a city when one was enough. 

The top layer however is about innovation.  New services can emerge and try their
luck with customers. They then either prosper or die without any impact on the
lower stacks. This is the beauty of the stacked architecture. 

Over time, it has even allowed new business models to attack the bread and butter
of incumbent service providers. Companies like Skype or WhatsApp for example
have completely destroyed the short messaging market value. 
They are now eating the industry voice revenue and pressuring the incumbent
players cost structures. The telecommunication industry was far from being the
only one deconstructed. Banking or even the good old energy industry are other
examples.

What did that mean for incumbents? 

It meant that the competitive landscape has changed dramatically. In addition to
the traditional competitors, incumbents can now be attacked by smaller players
that target only specific layers in the industry stack. 

Let's take an example. Traditionally, telcos were worried about other telcos. Today,
they're worried about WhatsApp as we have mentioned or Netflix. Both players use
the telecommunication infrastructure but they use it in a way that destroys a
traditional value pool of the infrastructure operators themselves.

Let me recap the most important messages of this session. Technological evolution

change the traditional model of  business architecture from a vertically integrated
value chain to a stack-based structure. The stack structure reflects the fact that
players can compete on different key success factors in different layers; scale at
the bottom, innovation of the top. In this new model, new players can disrupt
incumbents by attacking only a specific portion of the whole value chain.